The Shape of the Bailout

Through smoke and fumes, this week we see the outline of the monster that is the mortgage bailout. While measures that exist as of now are not enough to keep housing prices stable or rescue the economy from the deflationary spiral it is in, there is enough at the point to accomplish the fundamental goal of the regulatory effort: that is, saving the banks.

With the conservatorship of Fannie May and Freddie Mac, the Treasury Department will continue to underwrite their traditional economic functions. The federal government will buy troubled mortgages from banks, I imagine at near face value, floating Treasury Bonds as needed to pay for them—such that the Treasury Department holds the mortgage stinkers, bought for with bonds that will be paid off by the taxpayer over time. Banks now have the opportunity to become re-capitalized from recent losses and dump toxic mortgage securities all at once. There is no limit on securities the Treasury Department can buy. I wonder if there are any restrictions at all as to the quality of the loans.

An interesting test of the bailout will be Washington Mutual. All evidence is that they are about to fold. Their bond rating has been cut to junk today. But if in the next week WaMu can dump toxic mortgages on to the treasury department in exchange for T-bills, and survive, then if they can turn around, most likely any bank can. It may still be too late for them. The coming days will tell.

So, does this rescue the economy? It only helps banks that I can see. Congress has given distressed mortgage holders a break, that the Treasury Department will honor, but they will still owe a premium on the properties they bought, that will still consume much of the American consumers' disposable income with high interest and principle payments—that even after the rescue will still be disproportionate to comparable rents.

The only way to stave of the deflationary recession that comes from a credit unwind is to make up for the monetary deficit by printing cash. If the Treasury Department wants to actually stabilize prices, printing is what it will have to do. Hyperinflation would be the consequence. For reasons stated before, that is not what I think they will do. But I would not fully rule out the possibility, and you shouldn’t either if a lot of your money is sitting in the bank. Further bailout policies and any expansion of the base money supply will be reported here as they occur.